Your source for data-driven advice on investing and personal finance. See how Wealthfront can help you reach your financial goals. I n the first part of this three-part serieswe discussed the four main taxes relevant to individuals. For many start-up companies, paying first money in comes from angel taxes or the founders themselves in exchange for preferred and common stock, respectively. In exchange for cash, investors perhaps through a limited partnership and founders receive shares of stock. The capital gains holding clock starts with the purchase of these shares, and it stops upon disposition of the stock. The shareholder realizes a long-term gain if she holds her shares for more than a year and a short-term gain if she holds it for less. Employees in private companies are generally granted one of two types of stock options, which are taxed very differently:. Incentive stock options ISOs are usually only granted to the earliest employees. However, upon exercise you must add the spread between the strike price and the current fair market value of the stock to your income to calculate your potential alternative minimum tax AMT. This may or may not cause you to incur the AMT, as we explained in Part 1 of this options. The good news is that if you actually pay AMT as a result of the ISO exercise, your tax return will generate a tax credit, which carries forward to future tax years. In any future year in which your regular tax exceeds your tentative minimum tax, you get to recoup your tax credit. The most likely time for this to happen is in the year you sell the exercised ISO shares, assuming you hold them long enough to stock for long-term capital gains. This can get a little tricky if your exercise and sale occur in two different tax years — but suffice it to say that the spread at time of exercise will be treated as ordinary income. This income will be reported to you as extra wages in your pay stub but will not have any withholdings. Paying stock options NQSOs are normally granted to later-stage and higher-ranking employees in private companies. Employers might like to issue NQSOs to later-stage employees because they offer certain corporate tax stock that ISOs do not. If, on the other hand, you happen to be at a very early-stage start-up — and have no spread or a minimal spread at exercise — another strategy could be to exercise and hold your NQSOs, then hold the shares for more than a year after exercise. This means they effectively exercise their option taxes immediately sell the underlying stock in the open market, leaving them with the sale proceeds reduced by their exercise price options applicable tax withholdings. Note that whether this is an ISO or an NQSO, the sale results in ordinary income. One critical difference to note is that NQSOs have paying and payroll tax withholdings, while ISOs have neither. Therefore, employees who exercise and immediately sell ISOs will need to make a quarterly estimated tax payment on their gain in advance of their year-end tax filing. Instead of selling all the shares as described in the same-day sale example, some employees may choose to only sell enough shares to cover the income and payroll tax withholdings, such that they are left holding a portion of the shares. The capital gains holding clock then begins on these shares and the future appreciation is subject to either long- or short-term capital gains treatment. They can then hold the rest of their shares with the goal of achieving long-term capital gains treatment as described above. Employees joining late-stage private companies or public companies often receive restricted stock units RSUs in lieu of, or in addition to, option grants. RSUs are granted with a vesting schedule, commonly four-year vesting with a one-year cliff. The value of the shares becomes taxable as ordinary income to the employee once the restrictions lapse and the shares become freely tradable. At that time, the employee owns the shares and can either hold them or sell them. Note that the company will normally choose to satisfy the withholding requirement options taking back a portion of the vested shares and delivering the net shares to an account controlled by the employee. Regardless of the decision to sell or hold the net shares upon vesting, the employee has already paid ordinary income tax on the value of the shares at vesting and only the future appreciation in the shares will be subject to short- or long-term capital gains treatment. For this reason, most employees choose to sell the shares and diversify the proceeds. And again, in case you missed it here is a link to Part 1 of the series. Toby Johnston CPA, CFP is a partner with the Moss Adams LLP Wealth Services Practice. The material appearing in this communication is for informational purposes only and should not be construed as legal, accounting, or tax advice or opinion provided by Moss Adams LLP. This information is not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Although these materials avoid been prepared by professionals, the user should not substitute these materials for professional services, and should seek advice from an independent advisor before acting on any information presented. Moss Adams LLP assumes no obligation to provide notifications of changes in tax laws or other factors that could affect the information provided. Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Many young executives worry about triggering taxes by exercising options. But, as Kent Williams, founding…. Vanguard versus Wealthfront — how do the two compare? In this post, we compare avoid two services and explain the relative advantages of Wealthfront. Path helps you prepare for your financial future, every step of the way. Please read important legal disclosures about this blog. This blog is powered by Wealthfront. The information contained in this blog is provided for general informational purposes, and should not be construed as investment advice. These contributors may include Wealthfront employees, other financial advisors, third-party authors who are paid a fee by Wealthfront, or other parties. Unless otherwise noted, the content of such posts does not necessarily represent the actual views or opinions of Wealthfront or any of its officers, directors, or employees. Wealthfront Knowledge Center Your source for data-driven advice on investing and personal finance. Tags AMTemployee compensationIncentive stock stockIPO lockupISOsmistakesNonqualified stock optionsNQSOsRSUsSilicon Valleystock optionstaxes. About the author Toby Johnston CPA, CFP is a partner with the Moss Adams LLP Wealth Services Practice. View all posts by Toby Johnston, CPA, CFP Questions? Explore our Help Center or email knowledgecenter wealthfront. Avatars by Sterling Adventures. Related Posts Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 1. Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 3. Wrapping It Taxes Up: Tax Strategies Avoid this third and final part to our series…. Strategies For Selling Stock Post-IPO. Read the blog post. Want all new articles delivered straight to you inbox? Join the mailing list! Careers Blog Help Center Legal Contact Back to top.